“Now everything changes for Italy.”“Spread goes through the roof.”“Spread alarm.” Just some headlines on the websites of Italian newspapers, Friday. With some sense of drama, they discussed the reaction in the financial markets to Thursday’s interest rate decision by the European Central Bank.
The ‘spread’ is the difference between the interest that Italy pays on government bonds and the interest that Germany pays on them. It is a financial stress indicator for the eurozone: the higher the spread, the higher the nervousness of investors about the sustainability of the sovereign debt of vulnerable euro countries such as Italy.
The stress is increasing. The Italian spread (for government bonds with a ten-year maturity) was still below 2 percentage points just before the ECB meeting on Thursday afternoon. Immediately after the meeting, the interest rate spread widened to 2.15 percentage points – and then rose to around 2.25 percentage points on Friday afternoon.
‘No problem’
Investors are responding to the strong message that the ECB gave on Thursday: we are going to fight inflation and to do that, interest rates must rise across a broad front. Higher interest rates should make borrowing more expensive, which should curb consumption and ultimately price increases.
Not only does the ECB want to gradually raise interest rates for banks, it will also stop buying new government bonds this month. With these purchases, the ECB has pushed interest rates on government debt in recent years, allowing European governments to borrow very cheaply. Since 2015, the ECB has bought up nearly EUR 5,000 billion in debt (government bonds, but also corporate bonds), more than six times the size of the Dutch economy.
The ECB will only stop buying extra bonds. The bonds already purchased will remain on the ECB’s balance sheet for the time being. And when the bonds already purchased expire, they will be replaced by new ones for the time being. But the ECB balance sheet will not grow any further.
After the ECB meeting, bond yields rose across Europe. The interest on Dutch government bonds, for example, rose from 1.65 percent to 1.78 percent. But proportionally, Italian interest rates (and to a lesser extent Spanish, Portuguese and Greek) rose additionally. Spreads are still far from the level of the euro crisis, when they were more than twice as high.
Carsten Brzeski, economist at ING, sees “no problem” for Italy yet. The current debts that the country has outstanding will only mature in seven to eight years on average. “So it will take a while before the higher interest really has to be paid,” says Brzeski on the phone.
Also read: The ECB’s interest rate hike is a gamble
Vulnerable countries
Not everyone within the ECB finds the current spread level worrying. It is quite normal that debt-laden Italy has to pay more interest than Germany, it is often said. ECB President Christine Lagarde promised on Thursday to prevent bond yields in the eurozone from diverging too widely. This stands in the way of effectively fighting inflation across the eurozone, she said.
To squeeze the spreads, the ECB would have to buy debt again, but this time targeting Italian (or Spanish or Greek) instead of debt of all euro countries. This can be done, the ECB has already suggested, by replacing non-Italian bonds bought during the corona pandemic and expiring with Italian ones. If this proves insufficient to control spreads, the ECB could deploy “new instruments”, Lagarde said.
At the height of the euro crisis, in 2012, the ECB already designed a program to specifically reduce the interest rates of vulnerable countries. Lagarde’s predecessor Mario Draghi had stated at the time that he would do ‘everything necessary’ to save the euro (‘whatever it takes”†
This program never had to be implemented – Draghi’s words alone were enough to allay the market turmoil.
A version of this article also appeared in the newspaper of 11 June 2022